Investment and returns in exploration and the impact on oil and natural gas supply

An econometric model is developed to explain the investment in
exploratory activity and the resulting accumulation of proved reserves
of oil and natural gas in the continental United States. The model
explicitly takes into account therole of geological uncertainty as well
as the effect of depletion in the context of a finite resource base.
The model for reserve additions describes the process of generating
new discoveries of oil and natural gas in two stages. The first stage
describes investment in exploration under conditions of geological
uncertainty and a continuing process of depletion of the hydrocarbon
resource base. Exploratory companies are assumed to choose a level of
investment that maximizes the firm's value after balancing expected
returns against the risks involved in exploration and the corresponding
costs. Combined with a characterization of costs of exploration and
development, this analysis leads to an expression for the total amount
of exploratory drilling in each production district in terms of
estimates of anticipated returns and anticipated risk. In the second
stage, the model predicts the parameters of the size distribution of
alternative drilling prospects, and updates them from period to period
to reflect the continuing process of depletion of prospects as well
as new information on geological and economic variables. The amount
of drilling activity can then be translated into actual discoveries
of oil and natural gas through the estimates of success fractions and
sizes of discovery (conditional on a success), which depend on these
parameters. Structuring the model in this way enables us to take
account of possible shifts in the relative proportions of extensive and
intensive drilling as a result of changes in economic variables.
Additions to proved reserves can also occur as a result of
extensions and revisions of existing fields and pools. Extensions and
revisions are modelled as functions of previous discoveries, exploratory
wells drilled, existing levels of accumulated reserves and production,
and an index of geological depletion.
An important aspect of the model is that it gives explicit
consideration to the process of long term geological depletion as
well as the role of risk in determining the amount of exploratory
activity. It also accounts for the fact that on the level of new discoveries oil and natural gas are in fact joint products, and
must be treated symmetrically. Finally, the model allows for shifts
in the relative proportions of intensive and extensive drilling in
response to changes in economic incentives.
The model is estimated and simulated to verify its pre-
dictive validity over a historic period. It is then used to examine
the influence of alternative regulatory policies on the oil and natural
gas reserves and production. Combined with an existing model of
demand for oil and natural gas (the MacAvoy-Pindyck Model), this
provides a basis for estimating future shortages and increases in
economic incentives needed to ameliorate them.

Description:

Originally presented as the author's thesis (Ph.D.), M.I.T. Alfred P. Sloan School of Management